The U. S. Dollar In 2016 And Beyond

by: John M. Mason

Summary

The value of the US dollar rose throughout 2015 posting gains in the 10 percent to 12 percent range against currency indexes.

This "strong" dollar was achieved almost accidentally as the US economy grew relatively more strongly than most other countries in the world.

In 2016, the factors are in place for the US dollar to remain strong, but the monetary (and fiscal) authorities are going to have to recognize this to perform well.

Paul Volcker, former Chair of the Board of Governors of the Federal Reserve System, has written, "a nation's exchange rate is the single most important price in its economy…."

This quotation comes from the book he wrote with Toyoo Gyohten, who worked in the Japanese Ministry of Finance, titled "Changing Fortunes: The World's Money and the Threat to American Leadership" (New York: Times Books, 1992, p. 232.)

Since the end of 2014, the United States dollar has strengthened against almost every currency in the world.

At the end of 2014, the value of the Euro in terms of the dollar was around $1.22. On December 24, 2015, the Euro was around $1.09, just about a 12 percent rise in the value of the dollar. On March 13, 2015, the value Euro was under $1.05 and on December 7, the Euro was near $1.08.

The Federal Reserve has two trade-weighted indexes, the first one considers 20 major trading partners and the other considers other important trading partners.

Against the currencies of 20 major trading partners the US dollar rose in value by just over 11.0 percent. Against the currencies of other important trading partners, the US dollar rose just about 10.0 percent.

All in all, the dollar performed quite strongly in 2015. What was going on?

Basically, the reason for the performance of the US dollar was that the US economy was out-of-sync with the economies of most other countries in the world and this meant that the monetary policy followed by the United States was the reverse of what most other countries were doing.

Whereas, most of the rest of the world were experiencing problems with economic growth and consequently looked to their central banks for further monetary ease, the situation in America was one in which the Federal Reserve looked to increase its policy rate.

The first index, the 20 major trading partners included Japan, Europe, and other leading industrial nations. These countries were experiencing low, or even negative, growth in their economies.

The other trading partners were generally emerging nations that had benefited greatly from the earlier quantitative easing of the Federal Reserve System and strongly rising commodity prices. As the Fed ended its third round of quantitative easing in October 2014, both commodity prices and the economies of emerging nations declined. This included China, Brazil, Argentina, Venezuela, Chile, and Columbia, among others.

One can conclude from this description that the Federal Reserve did very little to encourage a strong US dollar, it just so happened that almost everyone else was worse off.

In 2016, most countries in the world are facing relatively weak perspectives for economic growth.

I am on record with a belief that US economic growth in 2016 will only be in the 2.0 percent to 2.2 percent range. I believe that most nations in the world will continue to suffer from depressed growth, meaningful in their own context.

I also believe that the weakness in growth in the United States and around the world is due to restructuring and not just due to austerity programs and such. If I am correct in this, this means that monetary and fiscal policies can do very little in the short-run to "goose" up the economy to achieve greater economic growth.

The consequence of this is that monetary authorities will face in 2016, more of the same thing they have been facing over the past few years. And, as we have seen in the past several years, monetary policy will have little or no effect in stimulating faster economic growth. Still, the monetary authorities will try.

This prospect means that the world will remain on the edge of a currency war. This was one of the things faced by the Federal Reserve in the fall of 2015.

As the Federal Reserve continued to stall in raising its policy interest rate because it did not want to be premature in raising the rate, other countries and the European Central Bank eased up on their monetary policies thus creating a greater divergence between US monetary policy and their own, which kept the value of the US dollar strong.

I further believe that if the Federal Reserve does not raise short-term interest rates in 2016 and even moves back down because the US economy comes in weaker than forecast, other central banks around the world will react further to offset what the Fed might be trying to do. This is currency war territory.

The other factor looming just offstage is the changing world financial system. For the past fifty years of so, the United States has been the hegemon of the global economy. It pretty much could do what it wanted.

The US policy of credit inflation begun in the early 1960s ended up destroying the post-World War II international financial system constructed at the 1944 Bretton Woods conference. The collapse was recognized when President Richard Nixon floating the US dollar in August 1971.

The continuance of credit inflation policies resulted in a decline in the value of the US dollar against major currencies from the early 1970s to just before the Great Recession took place.

In the new economic era we are evolving toward, the United States is not going to be able to get away with this kind of self-serving policy. The reason for this statement is that China is moving in to contest the position of the US.

The United States will still maintain its leadership position, but with China getting the approval from the International Monetary Fund to include the renminbi in the basket of world reserve currencies, the challenge continues. It is my belief that this challenge will get stronger and stronger over the next few years.

As a consequence of these changes, the United States and the Federal Reserve are going to have to begin to behave differently. The fiscal policy focus of the United States will have to change as well. I will be writing about these changes in the next few days.

But, the United States is now leading with one of the stronger currencies in the world, even if the position were attained accidentally. The reality is that the United States has a relatively strong currency and faces the possibility that other countries will react to offset any policy the Fed might produce but becoming even more aggressive in attempting to create further ease.

That is, the Fed will gain very little by acting just in its own self-interest.

The other side of the situation is the changes that are taking place in how the relative economic power in the world is being distributed. The United States must quite focusing primarily on just the short-run and must develop policies that will produce greater economic strength through rising labor productivity and innovation. This will allow the dollar to remain strong but also will help keep the United States competitive in global markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.